News Analysis date published New: 
Monday, July 9, 2012 - 10:00
New Date created: 
Monday, July 9, 2012 - 10:00
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Monday, July 9, 2012 - 10:00

This Ignored Stock is One of the Best in its Industry -- and Could Gain as Much as 60%

Monday, July 9, 2012 - 10:00am

For about a decade now, investors have been worried that consumers would "cut the cord" and replace their cable TV subscriptions with free online content, which has been increasingly available.

Truth is, this probably will never completely happen.

For starters, the programming content on the leading cable networks is world-class. These networks spend millions of dollars developing and creating movie-quality TV programs these days. An episode of the highly popular vampire series "True Blood" on HBO, for instance, costs about $3 million per show. In its fifth season, the show is scheduled for 12 episodes, meaning a total cost of about $36 million for this season alone. This rivals a lower-budget Hollywood movie, such as the recent comedy "Ted," and is simply something online providers can't compete with yet.

Equally important, these channels have realized consumers really value being able to watch their favorite shows via their smartphones or tablets. Returning to HBO as an example, in 2010 the network launched HBO Go, a web service that cleverly links streaming content with a cable subscription from traditional TV. Through the website or through a recently-released app, HBO subscribers can view all of the network's programming from practically anywhere.

The proof of the strength of these business models is seen in the solid stock performance of the companies behind these shows. During the past five years, the stock market is down slightly while the leading media players are up. Gains range from only a couple of percentage points to more than 100%. Even during a difficult economy, consumers have been willing to keep their cable subscriptions and make cutbacks elsewhere.

But now I believe I've spotted a disconnect in the industry.

Time Warner (NYSE: TWX), which happens to own the HBO channel as well as a number of other leading media assets, has been a laggard in terms of stock performance. This is likely due to negative sentiment that has carried over from AOL's (NYSE: AOL) disastrous decision to acquire the company at the height of the dot-com bubble in early 2000. Just one month after the merger, the Nasdaq market peaked in March 2000.

During the subsequent years, the Internet segment of the new AOL Time Warner Inc. steadily lost dial-up subscribers and advertisers. As a result, many of the expected synergies between Time Warner and AOL never materialized. In December of 2009, Time Warner announced it would spin off AOL.

Despite those turbulent years, many of the Time Warner's cable channels were able to remain highly popular -- these include HBO, Cinemax, TBS, TNT, CNN, Cartoon Network and truTV. These channels collectively have some of the highest penetration and viewership rates among networks. Time Warner also owns the Warner Bros film entertainment studio and a collection of publishing assets such as Time magazine, Sports Illustrated and Entertainment Weekly.

In another savvy move -- also in 2009 -- Time Warner spun off its cable transmission businesses into Time Warner Cable (NYSE: TWC), which is basically a commodity business that has high fixed costs and grows slowly.

Media assets, on the other hand, possess much higher profit models and are growing briskly, especially outside of the United States. HBO, for example, has about 93 million subscribers across 151 countries, while CNN is one of the most popular news channels internationally.

Investors have been slowly understanding just how different Time Warner became after the spin-off. The stock is up nearly 30% during the past two years, though it is still lagging its other archrivals.

Given Time Warner's leading collection of media assets and future growth potential, I think the discount the stock is trading at compared to rivals is unwarranted. Looking at the table above, Time Warner trades at lower price-to-earnings (P/E) and price-to-sales ratios than the other leading players in the industry. Yet its growth prospects are just as bright, especially since it doesn't own capital-intensive businesses anymore.

As far as other rivals go, Comcast (Nasdaq: CMCSA) still largely operates in the cable TV transmission business, though it has steadily moved to owning content. Walt Disney (NYSE: DIS) owns leading networks such as ESPN and ABC, but also operates in non-related businesses such as low-margin theme parks and cruise ships.

Risks to Consider: Cable TV content providers still face a long-term challenge against online rivals. So far, they have been successful in keeping their loyal subscribers and in developing high-quality online content. TV programming is an economically-sensitive business operation because it relies on advertising, but has proven resilient in the current economy.

Action to Take --> I find it justified that Time Warner's valuation ratios should trade at least at the industry average of 15 times earnings. Multiplying its 2012 earnings expectations of $3.20 per share by the industry average puts the stock price at $49 per share, or about 27% above current levels. Applying its sales expectations of $30 billion to the industry's price-to-sales average of 2.1 puts the stock at $61, or nearly 60% ahead of current levels.

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.